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This report attempts to look at important factors that have a bearing on the economic future of Hungary. The purpose of the report is to assess the viability of investments in Hungary. The conclusion of the report is that our company should not undertake investments in Hungary for the reasons listed below.
Hungary has very low stability in its exchange rate movement with the US Dollar. It has suffered huge fluctuations in the value of its currency, HUF. Sometimes these fluctuations have been as large as 50%. This would cause our company to lose significant amounts. In addition, due to the socialist nature of the government, there are few assurances that capital controls will not be placed on the foreign capital. The government has not been able to prove its seriousness regarding the reduction of debt, and continues to post record deficits. This continues to occur despite warnings by the IMF and a bailout package awarded to them a few years ago.
Hungary does have a few positive attributes, such as a high consumption rate. A high consumption rate protects against recessions caused by a fall in the export income, since private consumption is a large percent of the GDP and limits the decline in the GDP due to external shocks. In addition, the Hungarian National Bank remains hawkish in its policy measures, and lends confidence that the investors would not lose money due to inflation in the short term.
Overall, Hungary remains a high risk country, despite a revival of the economy in the last 2 decades. For Hungary to surface as a competitor to the major emerging economies, it must bring discipline to its fiscal policies.

Introduction

Hungary is a landlocked country in Central Europe. It is located in the Pannonian Basin and it is bordered by Slovakia to the north, Ukraine and Romania to the east, Serbia and Croatia to the south, Slovenia to the southwest and Austria to the west. The capital and largest city is Budapest. Hungary is a member of the European Union, NATO, the OECD, and is a Schengen state.
Hungary follows an intermediately open and free economic and political system. It has a sovereign currency, the Hungarian Forint (HUF). Even though Hungary is structurally and politically a part of the European Union, with rights of unfettered travel for citizens, it has its own monetary system. Hungary is a consumption based society that relies on exports for growth. It has very low investment, but has begun to benefit from the surge of export orders from Western Europe.
Hungary has traditionally had a small scale manufacturing economy, with resources geared largely towards agriculture. Hungary adopted the Communist system in the early part of the 20th century, thus becoming a part of the USSR. This dictated self sufficiency as the prime objective, and sacrificed growth as a result. Later, during the 60s, the Hungarian Socialist Workers' Party (HSWP) established a few principles on which the economy was to be run. These were a.) More power for State Enterprises, less power for private businesses. b.) price controls. c.) liberalization of import. These policies offered slight improvement upon the communist manifesto, and did not help to significantly grow the economy.
Hungary underwent privatization in 1990 due to the fall of the Communist USSR. This entailed privatization of property and businesses. Hungary used the proceeds from sale of property to reduce the National Debt, $21.2 billion then. The rapid shift from state ownership to free markets saw a huge amount of structural unemployment. Since the 1990s, the Hungarian economy has seen steady low single digit growth figures, thus doubling its GDP in 20 years.

Analysis

Low investment Rate
Hungary has a few structural problems in its economy. These problems are common to most countries in Eastern Europe. The biggest of the problems Hungary faces is a low Investment rate, and a very high consumption rate. While this fact saves Hungary from structural problems such as low consumption, it also limits Hungary’s ability to increase its GDP.
To understand the concept of Investment rate better, we could ponder the situation in China. In China, consumption rates are very low, while investment and export rates are high, as part of the GDP. This increasing Capital Formation in China causes it to become more and more dependent on exports. The day China ceases to find more export demand it would not be able to sell all its products, causing a deflationary depression. The only way to prevent a depression is to increase its consumption while reducing its investment rate. Hungary has a problem opposite that of China. It’s very low investment rate prevents it from increasing production significantly. So while Hungary faces few chances of a deflationary recession due to a fall in consumption, it is doomed to suffer from low growth.



Low Growth in Consumption
The other way of growing the GDP is by increasing consumption. Consumption rises because of an increase in investments by businesses in the form of saved capital. If a business saves its income and reinvests that portion, it would increase the production and allow for higher consumption in the future. But, due to low savings/reinvestments, the growth in consumption has been mediocre.



Low Export Growth
Since Hungary has a low investment rate, it cannot be expected to increase its exports significantly. Such an event would mean lower consumption, which can have very unfavorable consequences. Because of the low growth in exports, the export market share has remained steady, but not increasing.



Low rise in Real Wage and Productivity
Real wages and productivity are joined at the hip. In fact, both productivity and real wages are a reflection of the investment rate or the gross capital formation in the country. Since Hungary has low capital formation, its productivity per person does not rise and hence the wage earners do not see a relative increase in their standard of living.



Inflation
Hungary does not have very high inflation. This is due to the hawkish policies of the Hungarian National bank. The primary objective of the Hungarian National Bank is to maintain price stability. The non core inflation has often hovered in the high single digits, but has not been out of control. The primary reason for this is the low increase in the money supply.



Government Debt
The debt of Hungary has grown consistently over the last decade. The high debt and constantly high deficits are a reason for the low amount of investor interest in the country. Hungary's public deficit amounted to 4.2 percent of gross domestic product in 2010, down from 4.5 percent in 2009. The figure was way above the ratio of the 3.8 percent the government had been aiming for under the terms of a 2008 bailout deal with the European Union and the International Monetary Fund. Hungary has sticky pension entitlements which are difficult to renegotiate due to the presence of unions. Hungary posted a budget deficit in March 2011, causing the year-to-date figure to surpass the annual target by 8%. Such events show the non-seriousness of the politicians of Hungary, and pose serious danger to the investments of foreigners in the country.
Both private sector and public sector investment fall in value if a government defaults on its debt. This is because investors expect the inflation in the country to rise.
Moody's Investors Service in December 2011 downgraded the debt rating of Hungary to Baa3, one notch above junk, citing long term fiscal concerns and external vulnerabilities.



Taxation
Hungary has high individual taxation, but relatively low corporate taxation. The individual tax brackets are between 18 and 36%, while the corporate tax rate is fixed at 16%. (Taxation)
Foreign Exchange Loans
One of the biggest causes of the trouble Hungary has had in recent times is the amount of foreign exchange loans taken up by its banking system. 70% of the household loans made by the banks in the last decade were funded by FX loans to the banks. This means that a majority of the borrowings of the banks were in foreign exchange. This opened up the opportunity for high risks. As the economy of Hungary suffered during the 2008 crisis, many investors became afraid and withdrew their FX deposits. The risk of bank failures caused investors to sell their FX bonds and escape the country specific risk. This action created a scare that the Hungarian National Bank may not be able to fund all HUF transfers to Euros and Dollars. As a result, it prompted increased withdrawals of FX, causing the currency to plummet.





Currency
The Hungarian Forint (HUF) is a highly volatile currency. It has often fluctuated by more than 50% in the last decade, causing investors to lose vast amounts of money. Hungary is a recipient of money from the carry trade, thus seeing an increase of 50% between 2006 and 2008. And later, as the crisis developed, its currency went back to the 2006 levels within 6 months. This gives evidence of the high risk of investments in the HUF.



Conclusion

After taking note of the above factors, it would not be recommended to invest in Hungary. The prime risk to investments is in the form of Exchange rate risk, and credit risk. Until the Hungarian government sufficiently stabilizes the debt of the country, the exchange rate risk would remain. Hungary does have some positive attributes, such as a high consumption rate, low trade deficits. But, a low investment rate prevents the country from achieving greater growth. In addition, adherence to socialist economic philosophy and pension obligations prevents it from reaching its potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: The Risks of Investing in Hungary